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Battle Lines Form around Fiscal Cliff

Possible solution could include tax reform and changes to entitlement programs.

Battle lines have begun to form around the fiscal cliff. They will, of course, shift and waver in coming weeks. That is the nature of negotiations. In the process, financial markets will alternately suffer bouts of fear and relief. In all likelihood, the give-and-take will go on until the last possible minute. That, too, is the nature of such negotiations. But for all the doubts that will occur in the interim, it’s likely that in the end, the talks and maneuvers will keep the nation from going off the cliff. The exact nature of coming compromises remains vague, but the positioning to date gives at least a hint.

The feeling at the moment is that the Democrats have the advantage. The election, after all, put President Obama back into the White House, modestly enlarged the party’s Senate majority and gave Democrats small gains in the House of Representatives. But Republicans retain a solid majority in the House and have the ability to block legislation in the Senate. Especially since there is dissension within the two parties, neither side has the power to impose its will on the other. What is more, both sides face tremendous pressure to compromise. If each party hopes that the public would blame the other for failure, the prospect of a recession, which would almost certainly accompany a fall off the cliff, simply carries too much risk for most politicians. Even such tough partisans as Senate Majority Leader Harry Reid, D-Nev., and House Minority Leader Nancy Pelosi, D-Calif., have bowed to the imperatives of the moment and begun to talk in terms of “grand bargains” and “compromise.” Pelosi says bluntly, “We want agreement,” while Reid decries “brinkmanship.”

The biggest issue is the expiration of the Bush tax rates. Republicans want to extend the lower rates for all. President Obama and the left of the Democratic Party insist on keeping the rates low for all but higher-income earners. The president points to the election to claim that the majority of the public is on his side. He has a point, but it is not all his way. At least one-third of the House Republican caucus has pledged never to raise tax rates on anyone. Obama knows his election victory means little to these representatives. Their political careers would end if they broke their vow. Their seeming intransigence raises the risk of failure should the president stand firm on his point, and the president knows that failure would impose considerable pain on his constituents. Taxes would rise on the middle class as well as the wealthy. Non-defense discretionary spending would suffer more than $50 billion in cuts. Extended unemployment benefits would end suddenly, and the burden of the alternative minimum tax (AMT) would be imposed on much of the middle class. Medicare services would be weakened as a scheduled 27% cut in doctors’ fees would prompt many doctors to exit the program.

Faced with such an impasse, both sides might well embrace tax reform. Some way to reduce statutory tax rates while at the same time eliminating or capping tax breaks would offer a way out of the awkward impasse on the Bush tax rates. And reform proposals of this sort have found favor at times on both sides of the aisle. In the past, Republicans have only countenanced such reforms if they were revenue-neutral, but House Speaker John Boehner, R-Ohio, has already indicated that he would accept revenue enhancers, opening an avenue for compromise. Even Republicans who have taken the pledge against higher taxes could square increased revenues with their pledge, since tax rates would not rise in a reformed structure.

Right now, the president offers the biggest impediment to the reform solution. Though he has embraced such reform principles in the past, he wants first to impose higher tax rates on wealthier Americans and then negotiate reform from those higher rates. For this reason Obama has argued that eliminating or capping deductions would fail to provide sufficient revenue. “The math,” he says, “tends not to work.” But analysts on both sides of the political spectrum say the government could generate considerable revenue in this way. Those analyses have had an effect. Many, even within the president’s own party, seem reluctant to risk failure for the sake of the administration’s two-step process. A centrist group called the New Democratic Coalition has formed that includes at least one-quarter of the Democratic caucus, and it has made clear that it wants to embrace the new Republican openness to revenue increases within a reform effort. Combined with the 15 remaining conservative Democrats, the so-called “Blue Dogs,” mostly from Southern states, this new coalition could add considerable force for compromise.

Similarly, the pressure of the cliff seems to have made Congress more open to entitlement reform. Republicans, of course, built part of their presidential campaign around it. Now, while the Democratic left still rejects entitlement reform out of hand, the pressures of the moment have raised other voices within the party. Some would only permit minor adjustments, but others, led by Senator Dick Durbin of Illinois, would consider bolder ways to contain entitlement spending. Bolstered by work done at the left-leaning Center for American Progress, the new Democrat positions focus on raising the eligibility age for Medicare, introducing means testing for benefits and competitive bidding for some services, and seeking savings by replacing the fee-for-service system with payments for medical outcomes. Even Obama has tipped his hat to such proposals, though only in a general way. They are far from Republican positions, but no less a partisan than Senate Minority Leader Mitch McConnell, R-Ky., has characterized them as a basis for compromise.

While such compromises would still leave the country far short of complete fiscal reform, they would allow it to avoid the fiscal cliff, or at least the bulk of it. Any combination of entitlement and tax reform, especially with enhanced revenues, would count as sufficient deficit reduction to avoid the automatic discretionary spending cuts, the so-called sequestration, currently built into law and a big part of the fiscal cliff. Tax reform, even if it were to fall far short of ideal, would also sidestep the debate over the Bush tax rates and spare the economy that part of the cliff as well. Having jumped such hurdles, Congress could easily pass another annual AMT patch to block an extension of this particular burden to the middle class. Nor should Congress have difficulty protecting Medicare services by blocking the planned cut in doctor’s fees since it has done this so frequently in the past that the legislation has a nickname, the “doc fix.” Not only could the economy miss the fiscal cliff this way, but, for those with an optimistic turn of mind, the compromises, jury-rigged as they inevitably will be, might even lay the foundations of something more substantive.

About the Author

Milton Ezrati

Milton Ezrati is senior economist and market strategist for Lord Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo. His latest book, Thirty Tomorrows, linking aging demographics and globalization, will appear next summer from Thomas Dunne Books of St. Martin’s Press. See more of his articles about the economy here.

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